Three Ways to Protect Your Portfolio Against Stock Market Drops

By: Money_and_Markets

Nilus Mattive: June wasn't kind to the stock market. In fact, the S&P 500 had its worst month since September 2002 and its worst June since 1930.

So far, July hasn't been much better.

End result: The S&P 500 is now back below 1300, the same place it was at in the beginning of 2006. In other words, it has given up all the gains made throughout 2007.

In fact, the S&P 500 was at the very same 1300 level as far back as 1999. In between were massive rallies, sure. But over the last eight years, the market has basically gone nowhere.

You can see why I continue to think select dividend-paying shares are the perfect way to get paid while the market idles in neutral and interest rates remain insultingly low.

For your core income stock portfolio, I continue to recommend hanging on to those positions and riding out the turbulence. Remember, dividend-paying stocks have performed better during past bear markets than non-dividend-paying shares. [Editor's note: For more information on how dividend shares have done during past bear markets, see Nilus' special report " Why Dividends Will Almost Always Make You Money ."]

And as I mentioned two weeks ago, I also think strategies like dollar cost averaging work very well for putting new money to work in the kind of market we have right now.

Because, ultimately, I think the stock market will work through this bear market and resume its rise eventually.

Despite a massive drop and rally, the S&P 500 has been flat for the past eight years ...

However, I also realize that you may want to take out some insurance against further market declines in the shorter term. And that's why today I want to give you three ways to protect your portfolio against additional weakness ...

Strategy #1: Protect Your Capital Appreciation Plays with Stop Loss Orders.

Stop loss orders are instructions that tell your broker to sell your shares should they reach a predetermined price level.

For example, if stock XYZ is trading at $10 a share, you might give your broker a stop loss order of $8. Then, if XYZ hits that level, it will automatically be sold at the best price possible.

Please note that I did not say it will be sold at $8! While stocks with a lot of liquidity should get unloaded very near a stop price, there is the chance that the market will move down so fast that your order will get filled at a lower price than you specified.

Concerned about that possibility? Then place a stop limit, which is a very specific order telling your broker what range of prices you're willing to accept on the trade.

Note: I do not recommend stops for your long-term, income-generating investments, provided you believe the company is still viable and the dividend is reasonably secure.

That's because if you're constantly getting stopped out of positions, you will lose the current income, which is the real benefit of buying and holding dividend stocks.

However, choppy markets call for defensive measures when it comes to your shorter-term positions, especially if capital appreciation is the main goal.

You can even employ stops in your profitable positions as a way to lock-in gains in the event of a market decline. Simply raise your stop loss as the profits pile up.

Strategy #2: Consider Inverse Exchange-Traded Funds to Hedge Your Income Positions.

Essentially, these work in the same way as traditional ETFs, giving you an all-in-one-shot way to invest in a particular sector or market. However, they come with an interesting twist — they're designed to go up when that sector or market goes down.

More and more of these inverse funds are coming on the market. There are now inverse funds for everything from the Dow to real estate shares. There are even double inverse funds that will do the opposite of their targeted market times two! One such fund is the Rydex Inverse 2X S&P 500 ETF (RSW). If the S&P 500 falls 1%, this ETF should rise 2%.

The danger of an inverse ETF, especially a leveraged one, is pretty obvious — you will lose money fast if the market starts heading back up. This is why I'm not advocating selling your long positions and plowing the money into inverse funds.

Rather, I'm saying that a small position in an inverse ETF can be used as a way to cushion the effect of a down market on your overall portfolio. In other words, you could make money from the inverse fund to offset the paper losses the rest of your portfolio is experiencing.

Best of all, your dividend-paying positions would continue to throw off income the whole time. Assuming you're using a broad-market, regular inverse fund, every dollar you place in the ETF will roughly counteract one dollar's worth of your "long" portfolio.

Strategy #3: Diversify Your Portfolio With Alternative Assets.

I'm talking about things that aren't really correlated to stocks or bonds.

Instead, they often move in the opposite direction. Gold is the classic alternative investment, and it's been on a tear lately.

Reason: The yellow metal is viewed as a safe haven from other markets as well as inflation. If you want to add some gold, you can either buy bullion or an exchange-traded fund such as the SPDR Gold Shares (GLD), which holds physical gold in trust for its investors.

Keep in mind that there are also other more advanced ways to insulate your portfolio from weakness, especially strategies involving the use of options. Guys like Mike Larson are experts at using these instruments to not only help protect against downside but also to bag big gains when individual stocks and ETFs get pummeled.

Bottom line: While I always suggest you take a longer term view of the market, and not let the day-to-day movements get you down, I also want you to know that there are plenty of easy ways to build additional protection into your portfolio without compromising your income-generating positions.

Best wishes,

Nilus

P.S. If you want to know which dividend stocks can hand you great income while the market trades sideways, check out my Dividend Superstars newsletter. You can subscribe today and get 12 monthly issues for just $39!

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